Financial markets

Pensions

The Detroit precedent

THERE will be very real hardship for Detroit pensioners if the bankruptcy plan goes through; few retirees can accept a loss of 30% of their income with ease. And the average pension of a Detroit retiree is less than $19,000, according to the AFSCME union. But the case will also have broader implications for the public sector pensions in general, and in particular for their accounting treatment, on which this blog has opined at length. How much money we should set aside for pensions depends crucially on how secure the pension promise seems to be.

A pension plan is a multi-decade long promise; a worker who joins a scheme on leaving high school might be receiving payments 70 years later. It is thus vital that pension schemes account not just for the cash cost (contributions received, benefits paid out) on an annual basis, but for the long-term promise. This involves discounting the future liabilities at some rate to give them a present value.

Inevitably, this creates the scope for fudging. The higher the discount rate you use, the lower the present liability appears to be, and the less cash one has to stump up immediately. Using a high discount rate is thus a temptation whether the funding body is in the public sector (and has to call on taxpayers for cash) or in the private sector (where high cash payments may reduce profits). For an explanation of why it is wrong to expect high returns from our current position, see below*.

It is easy to assume, with a public pension, that any shortfall can always be made good later; that the local government will always be around. But the Detroit case shows the dangers of that reasoning.

The alternative view, taken by actuaries on this side of the pond and by many economists, is that pensions are a debt-like liability, and thus should be discounted using a bond yield. This is the basis for the accounting treatment of private pension schemes. The fall in bond yields in recent years has thus pushed up pension liabilities and kept many funds in deficit despite the rebound in equities. This valuation method can occasionally seem perverse but has a real world justification; if a company wants to shed its pension liability, it can do so via a buyout with an insurance company. The insurance company will use bond yields to set its price; lower bond yields mean a higher price will be charged.

The Detroit dispute pits the interest of bondholders versus pensioners. The bondholders argue that the pensioners are getting a better deal, in the form of a smaller cut to the value of their pot. But an argument over where pensioners sit in the creditor priority list shows that, when push comes to shove, pensions are treated as another form of debt. Round one to the financial economists' school.

But hold on a minute. Academics have argued that state constitutions and legal precedents have made pension promises hard to break. They are thus an extremely secure promise and should be discounted by the risk-free bond rate, the Treasury bond yield. Since Treasury bond yields are lower than those for other debtors, this pushes up the pension liabilities of states and local governments and makes the bill look bigger than before. Union activists have argued that this reasoning inflates the true cost of public pensions, and is really an excuse by the right-wing to attack workers' pension rights.

But if the Detroit package goes through, then it will be shown that pension promises can be broken. Thus a Treasury bond yield will not be the appropriate measure; something much more risky (and higher-yielding) will be needed. This will reduce the present value of pension promises and make public sector pensions look much more affordable. But one can hardly call this a victory for the union side.

* The custom in America has been to use the expected rate of return on assets as the discount rate. Inevitably, this has led to overoptimism; the current return assumptions are around 7.5-8%. The justification for such figures are based on the return that has been achieved in the past, particularly on equities. But the problem is that equity returns are a function of three things; the starting yield, the growth in profits (and thus dividends) and the change in valuation (which can increase or reduce returns). The past return figures used to justify current return assumptions often start in the early 1980s. But that was a period in which the starting yield was high and yields have since fallen, giving a further boost to returns in the form of a capital gain (a market that starts with a dividend yield of 5% and ends with one of 2.5% doubles in price, other things being equal).

In the current market climate, the dividend yield is low by historic standards, creating a low base for returns. Worse still, the market valuation might deteriorate in future (eg, a market that moves from a 2.5% yield to a 5% yield halves in price). In addition, bond yields are very low (as is the return on cash). So the expected return on portfolios must be lower than they were from the starting point of the early 1980s.

I would think the proclivity of a government to fudge math and over promise would affect the price of a private company taking over the liability. Is this the case? Is it not the case because in those transactions the insurance companies accept only booked liabilities? Is it not the case for another reason I haven't figured out yet?

The question came up because when, in the post, Brer Buttonwood talks about privatizing pension liabilities I imagined a bunch of Detroit City Councilmen deciding how many police to hire and what sort of pension to offer and thought that if I were in the very business of taking pension liabilities from municipal governments I would still not take a meeting in Michigan.

It is because insurance companies cannot enter into an open-ended commitment on pensions in a way that a company (or a local government) can do, nor can it take a punt that equities will do well (the regulators won't let it). It must hedge the liability. it usually does so by buying corporate bonds with similar maturities to the pensions payments it has promised to make. It then makes a profit by paying out less than the bond income it receives.
A similar process occurs if one buys a fixed annuity with a DC pension pot from an insurance company; the return is driven by bond yields

Another form of securitization, much like home mortgages. We all know how that turned out.

In a tranche of pensions, how would the insurance company dtermine the current medical condition, and long-term medical prognosis of superannuants?

I reckon someone working with asbestos would be Triple-A rated by the super agency, whilst someone whose parents were both centenarians might be regarded as a 'toxic policy'. Would these be discoverable in a Detroit tranche?

You cite the 30% cut number. It applies to most, but not all public employees. As in Wisconsin, the police are spared. Why has no one discussed this?!? In Massachusetts they tend to be the most over-paid public employees with the most ridiculous pensions. Am I wrong in assuming that this carries over to other states? If so, why are they always more or less exempted?

In Costa Mesa, Calif., lawmaker Jim Righeimer says he was a target of intimidation because he sought to curb police pensions. In a lawsuit in November, Righeimer accused the Costa Mesa police union and a law firm that once represented them, of forcing him to undergo a sobriety test (he passed) after driving home from a bar in August 2012.

The suit by lawmaker Righeimer also said that an FBI raid of the law firm last October uncovered evidence that an electronic tracking device had been attached to the underside of the car driven by another lawmaker, Steve Mensinger, one of Righeimer's allies in the pension fight.

The police union, the Costa Mesa Police Association, denies any knowledge of the purported tactics. It fired the law firm, Lackie, Dammeier, McGill & Ethir, after allegations of the harassment first surfaced. Several calls to the lawyer representing the firm, which is in the process of being wound down, went unanswered.

RICK KARR: Bob Lee’s been through some major changes over the past few years. He moved out to the country after a couple of decades in the city. And he went into a new line of work.

RICK KARR: Lee could have a new career because he retired from his old one with benefits for nearly thirty years; he was a police officer in the city of Vallejo, in the Bay Area, about midway between his church and San Francisco. He was able to retire at fifty with a pension and family health insurance benefits worth a total of a little over one hundred eight thousand dollars a year.
---
$7,000/ month cash
$1,500/ month paid health insurance

In addition to the discounting issue, consider as well that pensions are compensation and that public employees have traditionally deferred a larger percentage of their income as pensions - and have often, if not usually been removed from social security. Take out the social security equivalent level of payments to set a base and the extra is the amount by which pension promises are additional compensation.

Two points. First, if you negate the deferred compensation promises, then you alter the bargaining value of deferred compensation. That means you either have to pay more in current benefits - like salary - or you simply cut pay. There has been a big round of pay cutting as public unions have been crushed but it's a question whether over time you can keep paying public employees - like teachers - less. That is, unless you reduce the quality of employee. That becomes public dis-investment.

Second, the main reason police/fire get higher payouts is their public unions are stronger and are exempted from anti-union laws. A teacher strike angers people against teachers. A police/fire strike scares people and the politicians run from that. An irony: the police/fire unions have long recognized the pressure on pensions (and retiree healthcare benefits) is growing and have worked to increase current income through legislation that rewards "continuing education" with mandatory pay increases. I put that in quotes because teachers, nurses, etc. need "continuing education" to keep their jobs but police get extra pay for classes, some of which consist of credits given for their police experience. That plus absurd overtime rules are why all the highest paid employees in big cities tend to be police and firefighters. It's rather amazing to read about these guys making over $200k.

There is also a difference in funding between the police and teachers. Police are usually funded by a progressive income tax. By contrast, teachers insist on regressive property levies. Teachers are perceived as gouging their $70,000 salaries out of poor people making $10,000 or $20,000 per year. Teachers are also perceived as taking less fortunate people's homes away from them, so that teachers can sojourn in the lap of luxury. By contrast, if someone becomes disabled, and cannot earn as much income, the police charge them less (income taxes are proportional to income).

This creates quite a bit of unhappiness among the poor in those regions where unusually lofty property levies are oppressing the poor. Teachers would have better PR if they would be more merciful to the poor voters in their regions. Instead, teachers pull tricks like busing in renters to the polls at the last minute, and buying them lunches (or some other treat) if the renters vote additional property levies on poor homeowners.

Teachers don't determine how schools are funded. That's done by the states and they rely on local property taxes because of history and the way schools were seen as a community obligation many years ago. That choice has nothing to do with teachers but it does make the politics in some states weirder.

As with everything in pensions, it is complicated. It looks as if the DB plan is being kept open for existing employees http://www.crainsdetroit.com/article/20140222/NEWS/302239963
but as I understand it, the 34% reduction formula applies to current workers as well. Here is the sectiron of the plan
"GRS Adjusted Pension Amount" means, with respect to a Holder of a GRS Pension Claim, the
Current Accrued Annual Pension payable to such Holder as adjusted in accordance with the following formula:
(a) for such a Holder who is either retired and receiving a monthly pension or a surviving beneficiary, a 34%
reduction in the monthly pension amount; and (b) for such a Holder who is an Active Employee, a 34% reduction in
the monthly pension amount; provided that, with respect to Holders who are Active Employees, in the event the
unfunded liabilities of the GRS for the plan year ending June 30, 2014 are greater than the unfunded liabilities of the
GRS as of June 30, 2013, the reduction in the monthly pension amount shall be increased to the extent necessary to
ensure that there is no change in the amount of the underfunding between Fiscal Years 2013 and 2014

The documents are incomplete (e.g. Exhibit II.B is missing), but it looks like active workers and pensioners are treated equally only for ACCRUED PENSIONS.

However, for:

(i) FUTURE PENSIONS, Active Employees continue to accrue pensions at 1.5% of salary. This is not subject to the 34% haircut for accrued pensions.

This continues to be a generous pension plan. Furthermore, the funding of future pensions is at 10% of salary for PFRS and 5% of salary for GRS, which is likely overfunded.

So in future, this excess funding can be paid out as additional pension benefit to Active Employees. This is provided for in "E. Accrual of Future Benefits."

(ii) HEALTH benefits, it looks like only retirees take a haircut. Their health benefits are under OPEB (Other Post Employment Benefits) which suffer a haircut at the same rate as their pensions (whether Police/Fire or General). Their OPEB will also be transferred to a VEBA scheme, separate from the health benefits of Active Employees, and separate from the PFRS/GRS pension pots. In other words, this VEBA could be cut further without impacting Active Employees.

For active employees', their OPEB is not included in the haircut and there is a new line accruing 2% of salaries to fund it in the cash flow. This compares to 10% of salaries for Police/Fire Retirement Scheme and 5% of salaries for the General Retirement Scheme.

This is a huge difference, given that health liabilities at $5,718m are much larger than pension liabilities of $3,887m.

Furthermore, the Active Employees OPEB will likely be overfunded by the 2% of salaries accrual in the budget cash flow. Again, this excess funding can be paid out as additional pension benefit to Active Employees.

Thanks, I'm hoping to speak to an actuary today who has been through the details. But accrued benefits will be the big asset for any worker near retirement. I don't agree with you that a 10% contribution is likely to be an overfunding of a DB pension; quite the reverse. 10% is the average contribution into DC pensions and, as we know, they fall well short of DB outcomes. In britain, we work of 20-25% of payroll for DB

See Centre for Retirement Research website which will have a study showing that pre crisis annual contributions required were 4-5%.

Since then it has skyrocketed as the stock market collapsed and more contribution is needed to cover past liabilities. Here, they have already made all the adjustment to past liabilities so the contributions are only to fund future liabilities.

You are right the actuarial report is needed but what has been disclosed does not even have key tables.

But remember the required contributions are based on over-optimistic return assumptions; 7.75% in the case of Detroit. With a 60/40 equity bond split, that requires long-term equity returns in double digits, given current bond yields

Printing is the bank's war on pensions. Detroit et al are just the first of what is coming. Defined benefit pensions cannot be reasonably funded with negative real bond returns, and stock market bubbles that will similarly deliver negative real return for the next decade or so.

Detroit was talked into buying swaps with pension money, which delivered negative nominal returns. Thus Detroit pensions are among the first, but they will not be the last. The bank is also slowly printing away hapless employees' 401k plans and IRAs.

I haven't had time to read and digest the recent Society of Actuaries report (link in another comment), but it also looks like some engaging material for pension buffs. As you might hear elsewhere, the SOA and AAA are in some conflict at present, so be prepared for more dueling banjos on this theme.

Since we are on the topic, I have another pension item that may be of some long-term research interest for you. One of the more interesting ideas to gather steam in recent years is the notion of variable pension plans, wherein the growth of participants' benefits are defined in terms of actual returns on assets. This design potentially relieves some of the financial economics issues associated with discounting long-lived fixed income obligations, because the ultimate benefit delivered is defined in terms of the actual, achieved long-term investment return.

The benefit accrual in a given year is usually fixed (no ratchet with future salary), and grows subsequently with actual investment returns compared against the original target (a risk-free or perhaps low-risk yield) against which it is initially valued and funded. So let's say this year I accrue a benefit of $1,000 per year (payable when I reach age 65), and that is valued on a 4.0% discount rate to the tune of $10,000 present value, which is duly contributed to the pension plan. Actual return on the diversified equity and fixed income portfolio for 2014 (crystal ball, behold!) is -2.0%. My benefit accrual drops to $940 per year. The drop in liability mirrors the actual return on assets.

This is a very simple outline of the subject, and one that could raise a lot of follow-up questions and discussion, but there is an important basic point that the investment risk will remain largely with the participant, not the employer. If you are wondering, mortality risk will remain with the employer.

Most people who don't work in finance or make gobs of money would do very well to retire on some lifetime income. Perhaps fixed-dollar income presents too much risk for the taste of many employers. Variable pension plans (or variable annuities) might help bridge the gap between the "no guarantees" approach of defined contribution plans and the "unbreakable promise" that has been the ideal for pension plans.

A few US employers and unions have started to move on these, but unfortunately there is some risk that regulators (both pension and accounting) may take some time to come up to speed, and possibly even impede progress. At the same time, the actuarial community probably has more work to do in building a solid theoretical basis for the benefits design, funding, and financial reporting of these plans. Here's hoping a solution can be fashioned before long. Stay tuned!

thanks, I did read the SOA paper and it suggests the best approach is to use the risk-free yield plus a risk premium; this is based on bond yields and would result in a reduced discount rate from that currently being used. Whether it will be adopted is another matter, seeing as it would require higher contributuons
I think you latter point refers to what we call in europe notional DC; we have been in favour of this, see http://www.economist.com/blogs/freeexchange/2013/01/reforming-public-pen...

Just when your pension fund seems to be on its knees, there's always someone around to deliver the final coupe-de-grace. At least Detroit's pension fund was governed by trustees who could decide where to, and not to, invest their pool of employee and employer contributions (real, notional or deferred).

Across the other side of the Pacific, we are wondering how to break this news softly, that trustees of the future are likely to be over-ridden, and that pension fund contribution pools will join the slushing funds regularly doing a 'capital flight' in search of (but rarely finding) lower risk and higher return. When last estimated, US$4tr departed the US around 2009 for Emerging Markets, and US$4.2tr returned with the taper. I digress.

and seem well-progressed. It is likely the OECD progress plan will seek G20 Leaders' endorsement at November's Summit in Brisbane. Your pension fund is likely to be one of the new sources of global infrastructure investment, whether it is Bolivian ports, Indonesian toll roads, or hospitals in Lesotho.